Westpac says the US dollar may come under pressure ahead of November's midterm elections

The US economy is humming with unemployment near multi-decade lows, inflation back at target and GDP growth the fastest it’s been in years.

Unsurprisingly, the US Federal Reserve expects to move policy settings into restrictive territory in 2020.

While a clear tailwind for the US dollar, Westpac Bank says there’s a risk the greenback may weaken ahead of the US midterm elections.

After eight rate hikes in just under three years, monetary policy settings in the United States are no longer deemed to be “accommodative”, at least according to the US Federal Reserve.

After a decade of helping to boost the US economy, the tailwinds from ultra-low interest rates are now starting to dim with policy gradually moving towards neutral, where they neither add nor detract from economic activity.

Based on the median forecast from individual Federal Open Market Committee (FOMC) members, not only is policy likely to move to what are deemed to be neutral levels of around 3%, but above in the year 2020.

The chart below shows the median year-end FOMC member forecast for the Fed funds rate.

Westpac Bank

From the current rate of 2% to 2.25%, the FOMC median expects there’ll be another four 25 basis point rate increases over that period.

Sean Callow, Senior Currency Strategist at Westpac Bank, says it’s hardly surprising the Fed is considering taking policy into restrictive territory given the current strength of the US economy, nor why it’s helping to boost the US dollar.

“With the unemployment rate already in the mid-3% area and core inflation at 2%, it’s little wonder the FOMC is projecting the funds rate to rise above the long term or neutral rate,” he says.

“In a world where most policy interest rates are either close to or at post-GFC lows and those raising rates substantially are only in emerging markets anxious to shore up their currencies against the dollar, the medium term USD outlook remains broadly positive.”

Helped by renewed fiscal concerns surrounding Italy, acting to weaken the euro, as well as possible quarter-end flows, the Fed’s hawkish view likely contributed to the greenback’s strength on Thursday, seeing the narrow dollar index, or DXY, screech higher during the session.

However, while the US dollar has found renewed strength, Callow says it may not remain that way for long.

“Near term, there could be a mild pullback [in the US dollar] on profit-taking, with pricing already above 80% for a December Fed rate hike and plenty of event risk before then, notably the November 6 midterm elections,” he says.